1. Copyright © The McGraw-Hill Companies, Inc 2011 FLEXIBLE BUDGETS AND PERFORMANCE ANALYSIS Chapter 9

2. Copyright © The McGraw-Hill Companies, Inc 2011 9-2 Copyright © The McGraw-Hill Companies, Inc 2011 2 Deficiencies of the Static Planning Budget Larry’s Planning Budget

3. Copyright © The McGraw-Hill Companies, Inc 2011 9-3 Copyright © The McGraw-Hill Companies, Inc 2011 3 Deficiencies of the Static Planning Budget Larry’s Actual Results

4. Copyright © The McGraw-Hill Companies, Inc 2011 9-4 Copyright © The McGraw-Hill Companies, Inc 2011 4 Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget

5. Copyright © The McGraw-Hill Companies, Inc 2011 9-5 Copyright © The McGraw-Hill Companies, Inc 2011 5 Deficiencies of the Static Planning Budget Larry’s Actual Results Compared with the Planning Budget Since these variances are favorable, has Larry done a good job controlling costs? Since these variances are unfavorable, has Larry done a poor job controlling costs?

6. Copyright © The McGraw-Hill Companies, Inc 2011 9-6 Copyright © The McGraw-Hill Companies, Inc 2011 6 Characteristics of Flexible Budgets Planning budgets are prepared for a single, planned level of activity. Performance valuation is difficult when actual activity differs from the planned level of activity. Hmm! Comparing static planning budgets with actual costs is like comparing apples and oranges. We need FLEXIBLE BUDGETS  The relevant question is... “How much of the cost variances is due to higher activity, and how much is due to cost control?”

7. Copyright © The McGraw-Hill Companies, Inc 2011 9-7 Copyright © The McGraw-Hill Companies, Inc 2011 7 Improve performance evaluation. May be prepared for any activity level in the relevant range. Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons. Help managers control costs. Characteristics of Flexible Budgets

8. Copyright © The McGraw-Hill Companies, Inc 2011 9-8 How a Flexible Budget Works To a budget we need to know that: ◦ Total variable costs change in direct proportion to changes in activity. ◦ Total fixed costs remain unchanged within the relevant range. Fixed Variable

9. Copyright © The McGraw-Hill Companies, Inc 2011 9-9 Copyright © The McGraw-Hill Companies, Inc 2011 9 Preparing a Flexible Budget Larry’s Flexible Budget

10. Copyright © The McGraw-Hill Companies, Inc 2011 9-10 Copyright © The McGraw-Hill Companies, Inc 2011 10 Activity Variances Larry’s Flexible Budget Compared with the Planning Budget Activity and revenue increase by 10 percent, but net operating income increases by more than 10 percent due to the presence of fixed costs.

11. Copyright © The McGraw-Hill Companies, Inc 2011 9-11 Revenue and Spending Variances Larry’s Flexible Budget Compared with the Actual Results $1,750 favorable revenue variance

12. Copyright © The McGraw-Hill Companies, Inc 2011 9-12 Larry’s Flexible Budget Compared with the Actual Results Revenue and Spending Variances Spending variances

13. Copyright © The McGraw-Hill Companies, Inc 2011 9-13 Copyright © The McGraw-Hill Companies, Inc 2011 13 Now, let’s use budgeting concepts to combine the revenue and spending variances reports for Larry’s Lawn Service. Now, let’s use budgeting concepts to combine the revenue and spending variances reports for Larry’s Lawn Service. A Performance Report Combining Activity and Revenue and Spending Variances

14. Copyright © The McGraw-Hill Companies, Inc 2011 9-14 Copyright © The McGraw-Hill Companies, Inc 2011 14 A Performance Report Combining Activity and Revenue and Spending Variances 50 lawns × $75 per lawn 50 lawns × $30 per lawn

15. Copyright © The McGraw-Hill Companies, Inc 2011 9-15 Copyright © The McGraw-Hill Companies, Inc 2011 15 Because of the large unfavorable wages and salaries spending variance, Larry decided to add an additional cost driver for wages and salaries. The variance is due primarily to the number of hours required for the additional edging and trimming. So Larry estimates the additional hours and builds those hours into both his revenue and expense budget formulas. Larry’s New Budget Flexible Budgets with Multiple Cost Drivers

16. Copyright © The McGraw-Hill Companies, Inc 2011 9-16 Copyright © The McGraw-Hill Companies, Inc 2011 16 Flexible Budgets with Multiple Cost Drivers Larry’s Budget Based on More than One Cost Driver

17. Copyright © The McGraw-Hill Companies, Inc 2011 9-17 Copyright © The McGraw-Hill Companies, Inc 2011 17 Some Common Errors The most common errors in preparing performance reports are to implicitly assume that: 1. All costs are fixed or that 2. All costs are variable. The most common errors in preparing performance reports are to implicitly assume that: 1. All costs are fixed or that 2. All costs are variable. Assume all costs are fixed.

18. Copyright © The McGraw-Hill Companies, Inc 2011 10-18 End of Chapter 9